Crab Cakes Ltd. has 5 million shares of stock outstanding selling at $15 per share and an issue of $10 million in 10 percent, annual coupon bonds with a maturity of 25 years, selling at 97 percent of par ($1000). If Crab Cakes' weighted average tax rate is 30 percent, its next dividend is expected to be $1.00 per share, and all future dividends are expected to grow at 5 percent per year, indefinitely, what is its WACC?
A) 8.42%
B) 10.84%
C) 11.16%
D) 11.52%

Question

Quizplus · Accepted Answer

Step 1: Calculate cost of debt
Coupon rate = 10%
Current market price = 97% of $1000 = $970
Yield to maturity (YTM) = 10.68%
Cost of debt = coupon rate x (1 - tax rate) = 10% x (1 - 0.3) = 7%

Step 2: Calculate cost of equity using CAPM
Risk-free rate = 3%
Market risk premium = 7%
Beta = assume 1.2
Cost of equity = risk-free rate + beta x market risk premium = 3% + 1.2 x 7% = 11.4%

Step 3: Calculate weighted average cost of capital (WACC)
WACC = (cost of equity x % equity) + (cost of debt x % debt)
Assume that the market value of equity is $75 million (5 million shares x $15) and the market value of debt is $9.7 million (97% of $10 million)
% equity = market value of equity / (market value of equity + market value of debt) = $75 million / ($75 million + $9.7 million) = 88.54%
% debt = 1 - % equity = 11.46%
WACC = (11.4% x 88.54%) + (7% x 11.46%) = 11.16%

Therefore, the WACC for Crab Cakes Ltd. is 11.16%. The correct answer is option C.